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For BOJ's Kuroda, easing only grows harder

Governor wrestles with both low inflation and the side effects of his strategy

BOJ Gov. Haruhiko Kuroda's fight with the country's stubborn deflationary mindset continues. (Photo by Taro Yokosawa)

TOKYO — Bank of Japan Gov. Haruhiko Kuroda, who began his second term almost a month ago, now has more than low inflation to battle. He also has to deal with the side effects of the massive amounts of yen that the central bank injected into the financial system during his first term.

A little more than five years ago, Kuroda gave himself a 2% inflation target and promised to get prices rising at that pace within two years. The goal still appears far off.

In March, Japan's consumer price index, excluding fresh foods, rose 0.9% compared to 12 months earlier.

What Kuroda in the spring of 2013 thought would be a blitzkrieg has turned out to be a drawn-out war. His BOJ began in an ultra-aggressive manner, then turned more unconventional along the way. The central bank started purchasing exchange-traded funds and real estate investment trusts. It set a negative interest rate on the portion of reserves commercial banks keep at the BOJ. It began controlling the yield curve, keeping the 10-year government bond yield at zero.

Flooding the financial system with yen has taught the governor that monetary policy alone can only do so much. 

In its quarterly "Outlook for Economic Activity and Prices" report, released on Friday, the BOJ freed itself from a deadline to hit the 2% inflation target. After all, the time frame has already been pushed back six times.

Kuroda said the decision to ditch the deadline was made to avoid telegraphing policy actions to investors and fueling speculation. But it can also be considered an attempt to do away with anything that might interfere with the bank's current accommodative approach.

Economists' expectations jibe with that latter view. In a poll of 21 conducted by Nikkei QUICK News, 15 said they foresee no policy changes in the year ending March 2019.

The bank is holding the benchmark interest rate at minus 0.1%, and the yield on 10-year Japanese government bonds — the long-term benchmark — near 0%. To keep rates at that level under its yield-curve control policy, the bank will increase its JGB holdings by about 80 trillion yen ($732 billion) a year.

The BOJ also buys 6 trillion yen of ETFs and 90 billion yen of Japanese REITs annually. These asset purchases are aimed at trimming risk premiums and promoting investment to stimulate the economy and create inflation.

The bank intends to continue this easy policy until inflation is stable at 2%. Expectations of low inflation are so entrenched in Japan that the rate has to actually pick up before the majority of companies start raising prices and wages.

"I think the possibility of inflation reaching 2% in fiscal 2019 is still high," Kuroda told reporters on April 27. But either way, the governor is likely to have his hands full this term.

The enormity of the unconventional program means that, if the BOJ did decide to head for the exit, it would be difficult to roll things back. On the other hand, carrying on with easing will only make for more intense side effects — effects the bank has already partly recognized.

As a percentage of gross domestic product, the BOJ's balance sheet stands out from those of its peers. Before Kuroda became the governor, the proportion was just over 30%. It is now above 90%.

The European Central Bank's figure is just over 40%, while the U.S. Federal Reserve's is slightly above 20%.

JGBs make up the largest portion of the bank's balance sheet. Since the BOJ already holds over 40% of the JGBs issued, further purchases could draw accusations that it is monetizing debt. But tapering the purchases or reducing the holdings could cause yields to jump, rocking the economy.

The ETFs may be even harder to deal with. The BOJ's ETF purchases certainly helped Japan's benchmark stock index touch a 26-year high. But Shingo Ide, chief financial engineer at NLI Research Institute, suggested the "BOJ may end up holding over 20% of Uniqlo operator Fast Retailing by March 2020" if the buying continues at the current pace. The central bank's policy has the potential to distort not only stock prices but the shareholding structure of corporate Japan.

Unlike bonds, though, ETFs have no maturity. To reduce its holdings, the bank has to actively sell them, which could hit stock prices hard.

Meanwhile, Kuroda's unconventional monetary policy has damaged commercial banks' profitability and weakened their position as financial intermediaries.

Known as one of the country's most unproductive sectors, the banking industry is in streamlining mode. Institutions are resorting to layoffs and pursuing mergers and acquisitions to regain profitability and their intermediary role. But if a crisis were to hit during this process, the economic havoc could be especially severe.

Political uncertainty could weigh on Kuroda as well. Prime Minister Shinzo Abe, the most important champion of the governor's easing strategy, is in danger of losing his grip on power as scandals hurt his approval numbers. "There is a 70% chance of Abe being gone by the end of the year," said Takuji Okubo, chief economist at Japan Macro Advisors.

Kuroda seemed restrained at his April 27 news conference — almost as if he knew his second term would be tougher than his first. Gone was the spirited trailblazer of 2013, who was ready to finally pull the economy out of the clutches of deflation. But a steady hand may be just what the governor needs for the balancing act that awaits him: chasing 2% inflation while ensuring the bank's policy is sustainable and minimizing the collateral damage.

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